Islamic Finance: Relevance and Growth in the Modern Financial Age

London School of Economics

1 February 2007

Iqbal Khan Founding ex-CEO, HSBC Amanah

Islamic Finance: Relevance and Growth in the Modern Financial Age | 2

Agenda

1. What is Islamic finance?

2. What relevance does it have in the modern financial system?

3. What are the areas of current growth and initiatives?

4. What does the future hold?

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Banking and finance needs

Islamic finance is the outcome of religion in banking

Shariah filter

Islamic banking and finance solutions

• Prohibition on:

– Interest

– Speculation

– Gambling

– Quran

– Sunnah

– Ijma’ (jurist consensus)

– Qiyas (analogy)

– Ijtihad (reasoning)

– Musharaka - Partnership

– Mudaraba - Partnership

– Murabaha - Purchase-resale

– Ijara - Lease

– Istisna’ - Manufacturing contract

– Salam - Forward sale

• Asset-backed transactions with investments in real, durable assets

Fiqh al-Muamalaat contractsShariah sources

• Prohibition of certain investments:− Sectors (e.g.: alcohol, armaments,

financial services, gambling, pork, pornography, tobacco)

− Instruments (e.g. no forward transactions, limited option use, no derivatives, short-selling)

• Credit and debt products are not encouraged

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– Synthesis of Islamic law and contemporary finance

– Community banking: serving communities, not markets

Islamic finance is more than financial contracts

Client affinity

Fulfils aspirations

– Widens ownership base of society

– Offers “success with authenticity”

Alternative paradigm – Stability from linking

financial services to the productive, real economy

– Moral compass for capitalism

Responsible finance

– Builds systematic checks on financial providers

– Restrains consumer indebtedness

Inclusive propositio

n

– Open to all-faith clients

– Available to Islamic and conventional issuers

Parallel trends

– Ethical investment

– CSR initiatives

Islamic finance is embedded within values

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Values of good governance are central to Islam

Accountability to God raises level of awareness

Quranic code of ethicsBest practices of corporate governance

− Accountability and obligation to shareholders

− Integrity and ethical behaviour

− Fiduciary role and responsibility of board

− Vicegerent concept of accountability (2:30)

− Honest fulfilment of contracts (5:1)

− Prohibition against betraying any trusts (8:27)

− Prohibition against deriving income from cheating, dishonesty or fraud (4:29)

− Prohibition against bribery (2:188)

− Prohibition against concealing evidence (2:283)− Disclosure and transparency

“O ye who believe! Be ye staunch in justice, witnesses for Allah, even though it be against yourselves or (your) parents or (your) kindred…” (4:135)

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prohibited sectors

NGOsnot-for-profits

SOCIALIMPERATIVE

ZONE OFSUSTAINABILITY

Islamicbusinesses

ECONOMICIMPERATIVE

• Market-driven yet values-based

• Gradualist and evolutionary nature

• Symbiotic and synergistic relationship with mainstream finance

Islamic Financial Institutions are positioned in a “zone of sustainability”

Islamic finance characteristics:

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Market size estimated at USD 750 billion globally1

− Growing at 15 to 20% per annum1

− Within 8-10 years, industry estimated to capture half the savings of the 1.6 billion Muslim world2

Young industry

− Mitghamr Savings Associations (1963) & Tabung Hajji Malaysia (1967)− Islamic Development Bank (1974) & Dubai Islamic Bank (1975)

Industry has advanced from niche to critical mass

Market-driven proposition

− Retail customers historically the backbone of the industry− Tipping point in retail sector: Saudi Arabia, UAE, Bahrain and Kuwait− Self-regulating organisations, Standards bodies and Research and

Training Institutes

Global scale

− More than 250 Islamic banks worldwide operating in over 75 countries 3

− GCC accounts for two-thirds of global Islamic assets*

− Malaysia leading industry maturity and sophistication− Islamic Development Bank: largest pan-OIC financial institution

Industry is fragmented, with slowly internationalising playersSource:1: S&P Report ( 31 Aug 2006); 2: IIR Middle East (Apr 2006); 3 Bursa Malaysia “The Islamic Capital

Market” 2005; * HSBC analysis

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

2005 2010e

GCC Malaysia

66% growth

33% growth

Islamic banking assets as proportion of total (%) *

40%

20%

12%

30%

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Industry has developed a comprehensive product offering over its young history

1950s

60s

70s

80s

90s

00s

− Egypt and Malaysia pioneering institutions− Establishment of OIC (1969)

− Development of theoretical framework− Muslim-majority nation independence

− Islamic Development Bank (1974) and DIB− One country-one bank setup

− Advancement of Islamic products− Full “Islamization” of Pakistan, Sudan and Iran

− Entry of global institutions, e.g. HSBC

− Tipping point reached in some markets− Development of industry-building institutions

1970s

commercialbanking

insurance

1980s syndications

structuredand trade finance

1990s

equity

private equity

projectfinance

debtissues

2000s

structured products

1970s

1980s1990s

2000s

Evolving richness in productsDevelopment of industry

Industry has near like-for-like parity with conventional offering

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.

Reach and richness

Niche presence

Mainstream relevance

Conceptual exploration

Engaging with regulators

Reach and richness

Source: HSBC Amanah

Islamic finance industry is developing a global reach…

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Singapore: Active in developing Islamic finance

Germany: Saxony issues E100m Sukuk (2004)

UK: New legislation forIslamic mortgages (2003)

UAE: 30% of retail bankingis Islamic (2005)• Several institutions have

converted from conventional to Islamic

Malaysia: Islamic product and industry, development and sophistication leader

USA:Harvard workshopwith six regulators (1995)

China: Active member of IslamicFinancial Services Board (2004)

Bahrain: Leading Islamic financial centre, and housing regulatory bodies

Saudi Arabia: 95%+ of new consumer lending is Islamic (2006)• Retail market rapidly

converting to Islamic (2006)

Source: HSBC Amanah, Press Reviews

…with worldwide momentum from retail to regulator involvement

Each region is contributing in a unique way

Japan: JBIC exploring Islamic financing opportunities (Dec. 2006)

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GCIBFI (2001)Bahrain

Promoting industry in theory and practice

− Disseminating Shariah concepts & multilateral understanding between IFIs and public− Improving IFI practices, cooperation, professionalism and transparency

IIFM (2001)Bahrain

Development of global Islamic capital and money market

− Promoting active and regulated trading and capital flows− Catalyzing trading infrastructure, product innovation and information flows

Self-regulatory organizations bring credibility through standardization of practices

AAO-IFI (1991)Bahrain

Benchmark of Islamic accounting standards

− 56 accounting, auditing, governance and Shariah standards− Enhancing clarity, transparency and harmonisation

IIRA (2005)Bahrain

Reference point for IFI ratings

− Issuing sovereign, credit, Shariah quality and corporate governance ratings− Providing effective tool for informed investment decision-making

IFSB (2002)

Malaysia

Standard-setting body of regulatory and supervisory agencies

− Complementing Basel II Capital Accord − Key standards: risk management, capital adequacy & corporate governance

LMC (2002)Bahrain

Creation of active Islamic inter-bank market

− Creating secondary market for short-term Shariah-compliant treasury products− Enabling IFI management of liquidity mismatch

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Strong growth of OIC economies

Retail customer commitment

Institutional capital

Liberalisation of capital markets

Innovative product development

Resurgence of Muslim cultural values

EXPLOSIVE GROWTH OF ISLAMIC FINANCE

Industry is driven by fundamental factors

Why Islamic financing is flourishing

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Multinational banks have gradually increased their focus on Islamic finance

Mainstream institutions are embracing Islamic banking

Ad hoc participation

− Correspondent banking for IFIs− Tailored Private Banking services for HNWIs

Islamic client services− Dedicated Relationship Managers for IFIs− Dedicated Private bankers for HNWIs

Islamic window model− Committed unit for Islamic financial services− Citi Islamic (1996), HSBC Amanah (1998)

Dedicated Islamic subsidiary− Islamic subsidiaries of conventional banks− Joint ventures and partnerships

Market entry strategy

Defensive strategy Proactive strategy

• Service and retain existing Muslim clients

• Refine current proposition to reflect local needs

– Particularly important and economic clout of locals increased

• Protect and embed the brand

• Acquire new customers, especially wealthy locals

• Build a sustainable community banking proposition

• Benefit from higher growth rates of emerging markets

– Crucial as developed market growth slows

Evolving commitment

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Industry is reaching mainstream relevance in global financial system

Relevance to non-OIC countriesRelevance to OIC countries

• Reaching a broader market − Muslim-minority populations become inclusive,

economic, productive agents

• Alternative source of funding − Debt issuance with the widest acceptance− Attract “new-to-industry” investors with Shariah-

compliant funds and transactions

• Gateway to OIC markets− Regional preference of Islamic investors− Infrastructure investment opportunities

• Fulfilment of financial needs of Muslims− Islamic finance is the equilibrium choice

• Widens stakeholder base of society− Increases bankable population of economy− Increases economic efficiency as a result of

society’s increased engagement

• Enhances stability of financial model− Asset-based framework links financial services

to real economy

Islamic finance benefits are not exclusive to Muslims

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Within 8 to 10 years, as much as half the savings of the world’s then 1.6 billion Muslims would be in Islamic banks1

The global Islamic insurance (Takaful) market is estimated to reach USD 14.4 billion by 20101

Most Islamic financial institutions are highly liquid, and seek new asset classes and markets to diversify– Project finance requirements of USD 500 billion in 5 years2

– Capital markets developments: Malaysia – Sukuks account for 71% of 1H06 debt issues3

Islamic finance has also gained popularity in Muslim-minority countries

– Germany issued the first Islamic Eurobond (2004)

– UK’s first standalone Islamic bank (2004)

Trends of convergence and conversion– Ethical investing, community banking

– Conversion of banks: e.g. National Bank of Sharjah, Bank al Jazira, Dubai Bank

The industry has not yet reached its potential

Source: 1: IIR Middle East (Apr 2006); 2 Banker ME (June 2006); 3 RAM Islamic Ratings Services (2006)

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Islamic framework provides solutions for key limitations of conventional banking system

An ethical grounding prevents a wide set of problems

IFI solutionsConventional banking issues

• Growing consumer indebtedness− TSV maximisation ultimate goal− Systemic conflict between shareholders and

credit-financed customers

• Speculation-fuelled crises− 1997 East Asia Crisis− 1998 Russia− 1999 Argentina

• Shariah-based IFI is Taqwa-based − Regulation is reactive to corporate innovation− Shariah-based system prioritises God over

regulators – (SRO)

• Check on profit-seeking alone as sole business motive

− Investment channels towards ethical activities

• Prevention of speculation− Ownership is prerequisite of sale− Excessive risks are prohibited− The case for “Narrow Banking”

• Equitable distribution of risk and reward

• Asset/need-based approach to financing

• Regulation often reactive and lagging corporate misbehaviour

− Collusion between research and M&A teams− Enron, WorldCom, Arthur Anderson, Tyco and

other collapses

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An alternative banking model in development

Liabilities Assets

Investments

Deposits

Equity financing

mudaraba & musharaka

Debt financing

ijarah, murabaha, salam, istisna‘

Profit, not interest, becomes the basis for financial intermediation

Su

pp

liers

of

cap

ital

Productive economic

actors with capital needs

• Reducing debt-based products− Islam permits commercial debt for productive ends− Debt-based consumer products permitted on basis of need

− More the exception than the desired norm

• Building income-sharing products− Musharaka is true form of financing− Develop with “fixed” income payment profile

• Removing bias towards debt− Current tax, accounting and regulatory systems and risk-weighting

promote debt instruments

Key internal issues that need addressing…

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Shariah-based industry is the new vision

Shariah-based mindset is crucial direction for product development

Shariah-compliant products

Shariah-based solutions

Savings &InvestmentsIndebtedness

x

− Income-sharing products

− Shift from debt-based product offering

− Letter of the law− Replicating

conventional credit service offering

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Need for co-ordination to enable further development

A number of factors need to be engaged to bring success

Key enablers

• Dedicated people− Greatest intangible to enable Islamic finance and build its future− Human capital development: bankers and Shariah scholars

• Committed sponsorship− Academic input to formulate visionary framework and development− Capital sponsorship to bring plans to life

• Change in mindset− From Shariah-compliant to Shariah-driven products and services

• Education of all key stakeholders− To build understanding and awareness

• Proactive engagement− Regulators, practitioners and Shariah scholars to set a common agenda

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We must preserve what is distinctive about Islamic finance

– Industry regulations and governance heading towards mainstream globalization

– Balancing different elements of Shariah credibility

Concluding remarks

Current expanding reach and richness of Islamic finance

– Despite the absence of an enabling framework

– But at a cost: culture of exceptions, Shariah credibility, competitive disadvantages

To build an enabling framework requires concerted efforts

– Collaboration between IFIs, endowed industry institutions and regulators

– Exploration of narrow banking principles

Imperative is for moving to Shariah-based services

Japanese proverb:“Vision without action is a daydream.Action without vision is a nightmare.”

Thank you

Iqbal Khan Founding ex-CEO, HSBC Amanah